De-Dollarization — my two scents!

We have heard about the upcoming de-dollarization for decades now. The dollar is dead narrative is yet to take any meaningful form as the global economy continues to rely heavily on the U.S. dollar for international trade and financial transactions.

To understand why and what are the real hurdles to clear for a true de-dollarization of our monetary system we need to take a closer look at how the USD system really works.

In the current globalized economic system you want to trade with as many partners as possible in a seamless way. When India exports its food commodities to Sri Lanka, the trade happens in USD, India accumulates US Dollars.

Over 80% of global FX transactions and 50%+ of global trades and payments happen in US Dollar. More importantly, in the last 30 years competitors could not alter this massive USD dominance. The main reason for the dominance — fulfilling the role of Global Reserve Currency is an extremely difficult role to play.

Let’s take the ASSET side of the equation.

If India is going to be the economic powerhouse of the next decade, which is usually done through manufacturing and exporting goods and services to the rest of the world, like Japan did in the 80s and China in the 2000s. If India’s exports more and imports less from the outside world in USD terms, the country will accumulate USD foreign exchange reserves.

These USDs enter the domestic banking system, and ultimately the local Central Bank is responsible for managing this FX reserve buffer — that means keeping these US Dollars safe and liquid.

In our monetary system, keeping money ‘’safe and liquid’’ means avoiding credit risk and investing in deep and liquid markets that guarantee a painless turnover if necessary. The US Treasury market stands out as the global leader in this field: as big as 20+ trillion in size, liquid and underpinned by a deep repo ecosystem it ticks all boxes. No capital controls, democratic roots and the rule of law reinforce the case.

Most importantly, an ample supply of US Treasuries provide to the rest of the world what they need: a safe and liquid asset where to recycle the USD proceeds from their global trades.

As global trades increase, the world needs more Treasuries.

What’s the potential alternative to the USD and USTs?

Japan?

Its government bond market is 60%+ absorbed by the BoJ, and it is quite common for JGBs to go “no bid” multiple days in a row, not providing the best liquidity.

Europe?

With such a fragile monetary and non-fiscal union, and the only AAA countries potentially able to provide the world with safe collateral i.e German Bunds.

China? Russia? Brazil?

In China, navigating potential challenges may involve contending with a blend of capital controls. In Russia, issues related to the absence of a robust democracy and rule of law may arise, while in Brazil, corruption and recurrent instances of double-digit inflation present additional considerations.

Countries will be hesitant to take these risks when storing hard-earned FX reserves accumulated from selling goods and services abroad. The truth is that US Treasuries don’t have a valid competitor as a global vehicle where to invest FX reserves.

And now look at the other side of the equation — DEBT.

USD-denominated foreign debt held outside of the US is estimated to be around $65 trillion which is mostly held in the shadow banking system outside of the US. Which makes an orderly De-Dollarization nothing short of a modern day miracle.

Entities outside the US have accumulated this much USD debt to finance global businesses that buy and sell things in USD. This is the most important concept to understand, if you want to leave the system and ‘’De-Dollarize’’, you need to deleverage a $100 trillion worth of debt from the system.

As an example, let’s say India wants to walk away from the USD global system tomorrow. India walking away from USD-denominated trades would stop its organic inflows of USD and Indian businesses would be choked under USD scarcity as they need to repay and refinance their USD debt. If they don’t sell stuff in USDs, where will they get their USDs from?

When you de-leverage a debt-based system you are either bidding up the debt denominator (the USD) or you are witnessing tectonic geopolitical events (e.g. wars) where the world order is at stake.

In the case above, Indian corporates would be forced to either bid for cash USD (buying dollars with a weakening rupee) to try and keep up with servicing their Dollar debt or they would have to default on it hence losing any credibility and access to international credit markets.

Anticipating a methodical phase-out of the US Dollar appears improbable; rather, true de-dollarization is a gradual process, akin to the evolution of the English language into a global lingua franca.

The challenges faced in adopting a new world language draw parallels to the complexities inherent in transitioning away from the US Dollar. Such a shift is destined to unfold amidst seismic geopolitical events, and the journey toward a different global monetary system is bound to be fraught with considerable pain and adjustments.